Knowledge Enrichment Seminar for NSS Economics Curriculum Series 1 Macroeconomics: Macroeconomic problems and policies by Dr. Charles Kwong School of Arts and Social Sciences, The Open University of Hong Kong 1 Lecture Outline 1. How fiscal policy influences aggregate demand (Output and price level) 2. How monetary policy influences aggregate demand (Output and price level) 3. Do other government policies affect output and price level? (The case of minimum wage law) 4. Monetary policy 5. Inflation and deflation (quantity theory of money) 6. Unemployment 2 1. How fiscal policy influences aggregate demand (Output and price level) - Outline Marginal Propensity to Consume (MPC), Marginal Propensity to Save (MPS) Different types of budget Changes in government purchases The multiplier effect A formula for the spending multiplier The crowding out effect Changes in taxes 3 How Fiscal Policy Influences Aggregate Demand Fiscal policy refers to the government’s choices regarding the overall level of government purchases (G) or taxes (T). 4 How Fiscal Policy Influences Aggregate Demand Fiscal policy Definition of budget surplus: an excess of tax revenue over government spending (T>G). Definition of budget deficit: a shortfall of tax revenue from government spending (G>T). Definition of Balanced budget: tax revenue equals government spending (G=T). 5 How Fiscal Policy Influences Aggregate Demand Changes in Government Purchases (G) When the government changes the level of its purchases, it influences aggregate demand directly. An increase in government purchases shifts the aggregate-demand curve to the right, while a decrease in government purchases shifts the aggregate-demand curve to the left. There are two macroeconomic effects that cause the size of the shift in the aggregate-demand curve to be different from the change in the level of government purchases. They are called the multiplier effect and the crowding-out effect. 6 How Fiscal Policy Influences Aggregate Demand The Multiplier Effect When the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. Thus, total spending rises by more than the increase in government purchases. 7 How Fiscal Policy Influences Aggregate Demand The Multiplier Effect Definition of multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. The multiplier effect goes on and on. When consumers spend part of their additional income, it provides additional income for other consumers. These consumers then spend some of this additional income, raising the incomes of yet another group of consumers. 8 Figure 1 The Multiplier Effect Price Level 2. but the multiplier effect can amplify the shift in aggregate demand. $20 billion AD3 AD2 Aggregate demand, AD1 0 Quantity of 1. An increase in government purchases Output of $20 billion initially increases aggregate demand by $20 billion . 9 How Fiscal Policy Influences Aggregate Demand Consumption Function Consumption (C) = Autonomous Consumption (A) + MPC x Disposable Income (Yd) Thus, C=A + MPCxYd Disposable Income (Yd) = Income - Tax 10 How Fiscal Policy Influences Aggregate Demand The Multiplier Effect A Formula for the Spending Multiplier The marginal propensity to consume (MPC) is the fraction of extra income that a household consumes rather than saves. The marginal propensity to save (MPS) is the fraction of extra income that a household saves rather than consumes. MPC+MPS=1 Example: The government spends $20 billion on new planes. Assume that MPC = 3/4. Incomes will increase by $20 billion, so consumption will rise by MPC × $20 billion. The second increase in consumption will be equal to MPC × (MPC × $20 billion) or MPC2 × $20 billion. 11 How Fiscal Policy Influences Aggregate Demand The Multiplier Effect A Formula for the Spending Multiplier To find the total impact on the demand for goods and services, we add up all of these effects: Change in government purchases= $20 billion First change in consumption = MPC × $20 billion Second change in consumption = MPC2 × $20 billion Third change in consumption = MPC3 × $20 billion …………………………………………………………… Total Change = (1 + MPC + MPC2 + MPC3 + . .) × $20 billion Multiplier 12 How Fiscal Policy Influences Aggregate Demand The Multiplier Effect A Formula for the Spending Multiplier This means that the multiplier can be written as: Multiplier = (1 + MPC + MPC2 + MPC3 + . .). Because this expression is an infinite geometric series, it also can be written as: multiplier = 1/ (1-MPC ) Note that the size of the multiplier depends on the size of the marginal propensity to consume. MPC↓Î Multiplier ↓; MPC↑Î Multiplier ↑ 13 How Fiscal Policy Influences Aggregate Demand The Multiplier Effect Other Applications of the Multiplier Effect The multiplier effect applies to any event that alters spending on any component of GDP (consumption, investment, government purchases, or net exports). Examples include a reduction in net exports due to a recession in another country or a stock market boom that raises consumption. 14 How Fiscal Policy Influences Aggregate Demand The Balanced Budget Multiplier The Government Expenditure Multiplier The government expenditure multiplier is the magnification effect of a change in government expenditure on goods and services on aggregate demand. A multiplier exists because government expenditure is a component of aggregate expenditure. An increase in government expenditure increases income, which induces additional consumption expenditure and which in turn increases aggregate demand. 15 How Fiscal Policy Influences Aggregate Demand The Balanced Budget Multiplier The Autonomous Tax Multiplier The autonomous tax multiplier is the magnification effect a change in autonomous taxes on aggregate demand. A decrease in autonomous taxes increases disposable income, which increases consumption expenditure and increases aggregate demand. The magnitude of the autonomous tax multiplier is smaller than the government expenditure multiplier because the a $1 tax cut induces less than a $1 increase in consumption expenditure. 16 How Fiscal Policy Influences Aggregate Demand The Balanced Budget Multiplier The Balanced Budget Multiplier The balanced tax multiplier is the magnification effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged. The balanced budget multiplier is positive because a $1 increase in government expenditure increases aggregate demand by more than a $1 increase in taxes decreases aggregate demand. So when both government expenditure and taxes increase by $1, aggregate demand increases. 17 How Fiscal Policy Influences Aggregate Demand The Crowding-Out Effect The crowding-out effect works in the opposite direction. Definition of crowding-out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. 18 How Fiscal Policy Influences Aggregate Demand The Crowding-Out Effect As we discussed earlier, when the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income, and will therefore likely increase their own consumption. If consumers want to purchase more goods and services, they will need to increase their holdings of money. This shifts the demand for money to the right, pushing up the interest rate. 19 How Fiscal Policy Influences Aggregate Demand The Crowding-Out Effect The higher interest rate raises the cost of borrowing and the return to saving. This discourages households from spending their incomes for new consumption or investing in new housing. Firms will also decrease investment, choosing not to build new factories or purchase new equipment. 20 Figure 2 The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand Interest Price 4. which in turn Rate Money Level supply partly offsets the 2. the increase in $20 billion initial increase in spending increases aggregate demand. money demand . r2 3. which increases AD2 the r AD3 equilibrium MD2 interest Aggregate demand, AD rate . Money demand, MD 1 0 Quantity fixed Quantity 0 Quantity by the Fed of Money 1. When an increase in government of Output purchases increases aggregate demand . 21 How Fiscal Policy Influences Aggregate Demand The Crowding-Out Effect Thus, even though the increase in government purchases shifts the aggregate demand curve to the right, this fall in consumption and investment will pull aggregate demand back toward the left. Thus, aggregate demand increases by less than the increase in government purchases. 22 How Fiscal Policy Influences Aggregate Demand The Crowding-Out Effect Therefore, when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on whether the multiplier effect or the crowding-out effect is larger. If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise by more than $X. If the multiplier effect is less than the crowding- out effect, aggregate demand will rise by less than $X. 23 How Fiscal